1. copyright © 2003 McGraw Hill Ryerson Limited 7 - 1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 7 - 2 Chapter 7 Using Discounted Cash Flow Analysis Chapter Outline  Discount Cash Flows, Not Profits  Discount Incremental Cash Flows  Discount Nominal Cash Flows by the Nominal Cost of Capital  Separate Investment and Financing Decisions  Calculating Cash Flow  Business Taxes in Canada and the Capital Budgeting Decision  Example: Blooper Industries

3. copyright © 2003 McGraw Hill Ryerson Limited 7 - 3 Discount Cash Flows Discount Cash Flows not Profits  In Chapter 6 you learned to evaluate a project: Step 1: Forecast the projected cash flows. Step 2: Estimate the opportunity cost of capital. Step 3: Discount the cash flows at the opportunity cost of capital. Step 4: Calculate the NPV where NPV = PV of Cash flows – Initial Investment Decision: Go ahead with the project if NPV  0.

4. copyright © 2003 McGraw Hill Ryerson Limited 7 - 4 Discount Cash Flows Discount Cash Flows not Profits  In this chapter, you will learn more about Step 1: How to prepare cash flow estimates for use in a NPV analysis. This is not as easy as it sounds …

5. copyright © 2003 McGraw Hill Ryerson Limited 7 - 5 Discount Cash Flows Discount Cash Flows not Profits  Remember, forecasts of cash flows will not arrive on a silver platter, all ready to go into your analysis! You will have to deal with raw data supplied by consultants, production, marketing, etc. You will also have to adjust data prepared in accordance with accounting principals.  Accounting numbers use historic costs and accounting income, not market values and cash flows, which are necessary for a NPV analysis.

6. copyright © 2003 McGraw Hill Ryerson Limited 7 - 6 Discount Cash Flows Discount Cash Flows not Profits  Discounting accounting income, rather than cash flow, will lead to erroneous decisions.  For example: A projects cost $2,000 (C 0 ) and has an opportunity cost of capital of 10%. It has a 2 year life. It will produce cash revenues of $1,500 and $500. The project can be depreciated at $1,000 per year. Compare the NPV using cash flow to the NPV using accounting income.

7. copyright © 2003 McGraw Hill Ryerson Limited 7 - 7 Discount Cash Flows Discount Cash Flows not Profits

8. copyright © 2003 McGraw Hill Ryerson Limited 7 - 8 Discount Cash Flows Discount Cash Flows not Profits  Accounting NPV: + 500 + - 500 1.10 1.10 = $41.32 - 2,000 + + 1,500 + + 500 1.10 1.10 1.10 = -$223.14 ACCEPT THE PROJECT REJECT THE PROJECT  NPV of Cash Flow:

9. copyright © 2003 McGraw Hill Ryerson Limited 7 - 9 Discount Cash Flows Discount Cash Flows not Profits  Discounting the accounting income gives an entirely different result from discounting the cash flows! The Accounting NPV says to accept the project. However, this answer makes no sense:  The project is obviously a loser, since we only get our money back ($1,500 + $500 = $2,000 or the cost).  This means we are getting a zero return when we could be getting 10% in the market!

10. copyright © 2003 McGraw Hill Ryerson Limited 7 - 10 Discount Cash Flows Discount Cash Flows not Profits  The NPV of the cash flows gives the correct answer: This project is undesirable and should be rejected!  Remember: Projects are attractive because of the cash flow they generate. Therefore, the focus of capital budgeting must be cash flows and not profits.

11. copyright © 2003 McGraw Hill Ryerson Limited 7 - 11 Discount Incremental Cash Flows Look for Incremental Benefits  A project’s NPV depends on the extra cash flows it produces.  You should: 1. Calculate the firm’s cash flows if it goes ahead with the project. 2. Calculate the cash flows if the firm doesn’t go ahead with the project. 3. Take the difference, which gives you the extra, or incremental, cash flow of the project.

12. copyright © 2003 McGraw Hill Ryerson Limited 7 - 12 Discount Incremental Cash Flows Look for Incremental Benefits Incremental Cash Flow = Cash Flow with the Project Cash Flow without the Project -

13. copyright © 2003 McGraw Hill Ryerson Limited 7 - 13 Discount Incremental Cash Flows Look for Incremental Benefits  You may wish to ask yourself: Would this cash flow still exist if the project did not exist? No? Include the cash flow in the analysis. Yes? Do not include the cash flow in the analysis.

14. copyright © 2003 McGraw Hill Ryerson Limited 7 - 14 Discount Incremental Cash Flows Look for Incremental Benefits  Example 7.2 in your text: Intel is considering launching the Pentium III microprocessor. Cash flows from the sale of the new processors are expected to be in the billions. But, will these be incremental cash flows?

15. copyright © 2003 McGraw Hill Ryerson Limited 7 - 15 Discount Incremental Cash Flows Look for Incremental Benefits  Our with-versus-without principle means we must also think about the cash flows without the new processor. If Intel goes ahead with the new processor, then demand for Pentium II chips will fall. Cash flows from the sale of Pentium III chips must be reduced by the decrease in cash flows from Pentium II chips. No! These will not be incremental cash flows!

16. copyright © 2003 McGraw Hill Ryerson Limited 7 - 16 Discount Incremental Cash Flows Look for Incremental Benefits Incremental Cash Flow Cash Flow with the Project Cash Flow without the Project - = Cash Flow from the Pentium III plus the reduced cash flow from the Pentium II. Cash Flow without the Pentium III plus the higher cash flow from the Pentium II - =

17. copyright © 2003 McGraw Hill Ryerson Limited 7 - 17 Discount Incremental Cash Flows Look for Incremental Benefits  The trick in capital budgeting is to include all the incremental cash flows from a proposed project. Here are a some things to look out for:  Include all Indirect Effects  Forget Sunk Costs  Include Opportunity Costs  Recognize Investment in Working Capital  Beware of Allocated Overhead Costs

18. copyright © 2003 McGraw Hill Ryerson Limited 7 - 18 Discount Incremental Cash Flows Include all Indirect Effects  To forecast incremental cash flows, trace out all the indirect effects of accepting a project.  For example: Sometimes a project will hurt sales of an existing product.  Think of the Intel example we looked at. Sometimes a project will help sales of an existing product.  Adding a new route into an airport would increase traffic, adding new revenues.

19. copyright © 2003 McGraw Hill Ryerson Limited 7 - 19 Discount Incremental Cash Flows Forget Sunk Costs  Sunk costs are like spilled milk: they are past and irreversible outflows!  The way to identify a sunk cost is to see if it remains the same whether or not you accept the project.

20. copyright © 2003 McGraw Hill Ryerson Limited 7 - 20 Discount Incremental Cash Flows Forget Sunk Costs  For example: Your firm paid $100,000 last year for a marketing report for a new widget it has developed. If you pursue the new widget project, the cash flow for the marketing report is $100,000. If you do not pursue the new widget project, the cash flow for the marketing report is $100,000. This is a sunk cost … it remains the same whether or not you accept the project.

21. copyright © 2003 McGraw Hill Ryerson Limited 7 - 21 Discount Incremental Cash Flows Include Opportunity Costs  Most resources are not free, even if no money changes hands. Suppose your firm is considering building a factory on some land. Your firm purchased this land for $50,000. Its market value today is $100,000.

22. copyright © 2003 McGraw Hill Ryerson Limited 7 - 22 Discount Incremental Cash Flows Include Opportunity Costs  If your firm builds the factory, there is no out-of-pocket cost for the land.  However, there is an opportunity cost. That is the value of the foregone alternative use of the land. It could be sold for $100,000.

23. copyright © 2003 McGraw Hill Ryerson Limited 7 - 23 Discount Incremental Cash Flows Include Opportunity Costs  If we build the factory, we give up $100,000. Thus the opportunity cost equals the cash that could be realized from selling the land now. This is the relevant cash flow for the project evaluation.  Notice that the purchase price of the land is irrelevant to analyzing the project. Did you recognize it as a sunk cost?

24. copyright © 2003 McGraw Hill Ryerson Limited 7 - 24 Discount Incremental Cash Flows Recognize Investments in Working Capital  Net working capital is the difference between a firm’s short-term assets and liabilities. It includes:  Cash, Accounts Receivable and Inventories.  Most projects entail an additional investment in working capital.

25. copyright © 2003 McGraw Hill Ryerson Limited 7 - 25 Discount Incremental Cash Flows Recognize Investments in Working Capital  Investments in working capital, just like investments in plant and equipment, result in cash outflows.  At the end of the project, when inventories are sold and accounts receivable are collected, the firm has a cash inflow.

26. copyright © 2003 McGraw Hill Ryerson Limited 7 - 26 Discount Incremental Cash Flows Recognize Investments in Working Capital  Working capital is one of the most common sources of confusion in forecasting project cash flows.  Here are the most common mistakes: Forgetting working capital entirely. Forgetting that working capital may change during the life of the project.  Cash holdings, A/R and inventories will fluctuate over the life of the project. Forgetting that working capital is recovered at the end of the project.

27. copyright © 2003 McGraw Hill Ryerson Limited 7 - 27 Discount Incremental Cash Flows Beware of Allocated Overhead Costs  Accountants will allocate costs, such as rent, heat, or electricity to a firm’s operations. Allocated costs are not related to any particular project, but they must be paid anyways. An accountant may assign such costs to a project after it has been accepted. But, should they be included when deciding whether to accept the project?

28. copyright © 2003 McGraw Hill Ryerson Limited 7 - 28 Discount Incremental Cash Flows Beware of Allocated Overhead Costs  When analyzing a project for acceptance, include only the extra expenses which would result from the project. If a project generates extra overhead costs, they should be included in your analysis. However, if the firm would incur the overhead costs whether it takes on the project or not, then those costs are not incremental.  If they are not incremental, they should not be included in the analysis.

29. copyright © 2003 McGraw Hill Ryerson Limited 7 - 29 Nominal and Real Cash Flows Discount Nominal Cash Flows by the Nominal Cost of Capital  Real cash flows must be discounted at a real discount rate.  Nominal cash flows must be discounted at a nominal rate. Mixing and matching nominal and real quantities, such as discounting real cash flows at a nominal rate, will lead to incorrect decisions.

30. copyright © 2003 McGraw Hill Ryerson Limited 7 - 30 Nominal and Real Cash Flows Discount Nominal Cash Flows by the Nominal Cost of Capital  As long as you are consistent in your treatment of the cash flows, you will get the same results whether you use nominal or real figures. See Example 7.3.

31. copyright © 2003 McGraw Hill Ryerson Limited 7 - 31 Financing vs Investment Separate Investment and Financing Decisions  When analyzing a project, the first step is to determine whether it is worth undertaking. In other words, first determine whether the project has a positive NPV.  If the project is worth undertaking, then you determine how to finance it.

32. copyright © 2003 McGraw Hill Ryerson Limited 7 - 32 Financing vs Investment Separate Investment and Financing Decisions  Thus, when you calculate the cash flows from a project, ignore how the project is to be financed. Analyze the project as though it were all equity financed.  If the project will benefit the shareholders, then you can conduct a separate analysis of the financing decision.

33. copyright © 2003 McGraw Hill Ryerson Limited 7 - 33 Calculating Cash Flow Total cash flows are the sum of 3 components: 1. Cash flow from investments in plant and equipment. Most projects need upfront capital investments. 2. Cash flow from investment in working capital. Most projects require cash holdings, accounts receivable and inventory. 3. Cash flow from operations. A firm invests in plant, equipment and working capital in the expectation that they will generate operating cash flows.

34. copyright © 2003 McGraw Hill Ryerson Limited 7 - 34 Calculating Cash Flow Cash flow from operations (CFO)  There are several ways to work out CFO: Cash Revenues – Cash Expenses – Taxes Paid Net Profit + Depreciation (Cash Revenues – Cash Expenses) x (1- tax rate) + (depreciation x tax rate) Method 1 Method 2 Method 3

35. copyright © 2003 McGraw Hill Ryerson Limited 7 - 35 Calculating Cash Flow Cash flow from operations (CFO)  Given the Income Statement below, calculate the cash flow from operations using the 3 methods: Cash Revenues$1,000 - Cash Expenses600 - Depreciation Expense 200 = Profit before Tax200 - Tax @ 35% 70 = Net Income 130

36. copyright © 2003 McGraw Hill Ryerson Limited 7 - 36 Calculating Cash Flow Cash flow from operations (CFO) Cash Revenues – Cash Expenses – Taxes Paid Net Profit + Depreciation = $130 + 200 = $ 330 (Cash Revenues – Cash Expenses) x (1- tax rate) + (depreciation x tax rate) Method 1 Method 2 Method 3 = 1,000 - 600 - 70 = $ 330 = ($1,000 - 600) x (1- 0.35) + (200 x.35) = $ 330

37. copyright © 2003 McGraw Hill Ryerson Limited 7 - 37 Calculating Cash Flow Cash Flow from Operations (CFO)  Note that all 3 methods of calculating the cash flow from operations gave the same answer. CFO = $ 330

38. copyright © 2003 McGraw Hill Ryerson Limited 7 - 38 Taxes and Cash Flows Business Taxes in Canada and the Capital Budgeting Decision  So far, we have calculated taxable income by deducting depreciation: Taxable Income = Revenues - Expenses - Depreciation  However, in Canada, taxable income is based on a deduction called Capital Cost Allowance (CCA), not on depreciation: Taxable Income = Revenues - Expenses - CCA

39. copyright © 2003 McGraw Hill Ryerson Limited 7 - 39 Taxes and Cash Flows Business Taxes in Canada and the Capital Budgeting Decision  The terms depreciation and CCA are often used interchangeably.  Although both are forms of amortization, they are not necessarily calculated the same way. The depreciation a company reports on its income statement is generally calculated in a different manner from the CCA it reports to Canada Customs and Revenue.

40. copyright © 2003 McGraw Hill Ryerson Limited 7 - 40 Taxes and Cash Flows Business Taxes in Canada and the Capital Budgeting Decision  Depreciation cannot affect a company’s cash flows – it is only a book entry.  Only the CCA amount has an effect on cash flows by reducing actual taxes payable.  Thus you must substitute CCA for depreciation in your calculations of the cash flows from a project.

41. copyright © 2003 McGraw Hill Ryerson Limited 7 - 41 Taxes and Cash Flows Business Taxes in Canada and the Capital Budgeting Decision  Capital Cost Allowance (CCA) The amount of write-off on depreciable assets allowed by Canada Customs and Revenue against taxable income.  Undepreciated Capital Cost The balance remaining in an asset class that has not yet been depreciated in that year.  CCA Tax Shield Tax savings arising from the CCA.

42. copyright © 2003 McGraw Hill Ryerson Limited 7 - 42 Taxes and Cash Flows Business Taxes in Canada and the Capital Budgeting Decision  For calculating CCA, assets are assigned to different asset classes. These classes have specified CCA rates.  Most asset classes use a declining balance method for computing CCA.  CCA is deducted from operating earnings before calculating taxes. This reduction in earnings creates a tax shield.

43. copyright © 2003 McGraw Hill Ryerson Limited 7 - 43 Taxes and Cash Flows Business Taxes in Canada and the Capital Budgeting Decision  The tax shield generated by CCA generally has an infinite life. Most projects have a limited life span.  As a consequence, when computing NPV, we calculate the present value of the operating cash flow separately from the present value of the CCA tax shields.

44. copyright © 2003 McGraw Hill Ryerson Limited 7 - 44 Summary of Chapter 7 Here is a checklist to bear in mind when estimating a project’s cash flows:  Discount cash flows not profits.  Estimate incremental cash flow:  That is, the difference between the cash flows with the project and those without the project.  Forget sunk costs.  Don’t forget opportunity costs.  Beware of allocated overhead charges (e.g. for heat, light and power) which my not reflect the incremental costs of the project.

45. copyright © 2003 McGraw Hill Ryerson Limited 7 - 45 Summary of Chapter 7 Here is a checklist to bear in mind when estimating a project’s cash flows:  Remember investment in working capital.  Do not forget that working capital will fluctuate over the life of the project.  Do not forget to recover the working capital at the end of the project.  Separate the investment and financing decision:  Do not include debt interest or loan costs in evaluating a project. Treat it as an all equity financed project for purposes of evaluation.

46. copyright © 2003 McGraw Hill Ryerson Limited 7 - 46 Summary of Chapter 7  If you forecast nominal cash flows, which reflect the effect of inflation, discount those cash flows using a nominal cost of capital.  In Canada, a company’s tax bill is determined by its CCA, not its book depreciation. Use CCA when calculating the project’s cash flows. CCA tax shields have an infinite life. Projects have a fixed life.  Calculate the PV of the CCA tax shields separately from the PV of the operating cash flows when computing a project’s NPV.